Terms of Trade

Measuring It

$$Terms\; of\; trade=\frac{Index\; of\; average\; export\; prices}{Index\; of\; average\; import\; prices}\times 100$$

1. In the base year both indices = 100, so the terms of trade = 100.
2. A rise in the index is an improvement, because export prices have risen relative to import prices.
3. A fall in the index is a deterioration, because import prices have risen relative to export prices.
4. The index tracks relative prices only, so it says nothing about the volume of goods traded.

Worked Example

1. Start from a base year in which both price indices = 100.
2. We apply the formula to an improvement and then to a deterioration.

Causes of Change

1. Higher relative inflation at home raises export prices, so the terms of trade can improve.
2. Faster productivity growth can lower export prices, so the terms of trade can worsen.
3. A currency appreciation raises export prices in foreign currency, so the terms of trade tend to improve.
4. Changes in world commodity prices shift the terms of trade of commodity exporters and importers.

Impact of Change

1. An improvement means each unit of exports buys more imports.
2. This can raise living standards if export volumes hold up.
3. But dearer exports can cut the volume sold abroad, especially where demand is price elastic.
4. So the effect on export revenue and the current account depends on price elasticity of demand.

Does a rising terms of trade always leave a country better off?

1. In favour, an improvement means each unit of exports buys more imports, so if export volumes hold up a country can consume more for the same productive effort and living standards rise.
2. Against this, dearer exports can cut the volume sold abroad; where demand for exports is price elastic, export revenue and the current account can worsen, so the price gain is offset by a volume loss.
3. The cause also matters: an improvement driven by a currency appreciation can erode competitiveness, whereas one driven by higher world prices for a commodity exporter can be a genuine windfall.
4. On balance a rising terms of trade tends to raise welfare, but it depends on the price elasticity of demand for exports and imports and on what caused the change.